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Altria Group might have taken longer than its peers to make a first move in the burgeoning e-cigarettes market, but it has moved quickly since then to gain a strong momentum in the category. With the national rollout of its MarkTen product on the way and Green Smoke acquisition complete, the company is set to pose a stiff challenge to the existing e-cigarette leaders in the U.S. These players comprise, namely, Lorillard’s, NJOY and Logic Technology, and togetehr they hold ~80% of the market currently. Moreover, the company also signed a cross-licensing agreement with Philip Morris International, the world's largest cigarette manufacturer by revenues, to commercialize its e-cigarette brands internationally, which is expected to further bolster its position in the emerging category.

Altria is one of the largest tobacco companies in the U.S. with over a 50% market share in cigarettes and smokeless tobacco products. Its brand portfolio includes well known names such as Marlboro, Copenhagen, Skoal and Black & Mild. Cigarettes and smokeless tobacco products make up more than 75% of Altria's total value, by our estimates.

E-cigarettes are primarily nicotine delivery devices that work by heating a nicotine-infused liquid into a vapour, which a smoker inhales. The market for e-cigarettes in the U.S. has been growing strongly over the past few years. It is estimated to have quadrupled in size from around $500 million in 2012 to ~$2 billion currently. Some of the key factors driving strong growth in the category include increased awareness and trials, largely unrestricted marketing and a growing retail distribution. According to Altria's estimates, ~90% of adult smokers in the U.S. are now aware of e-cigarettes and around two-thirds of them have tried it. [1]

With a sharp rise in consumption, competition is also heating up in the industry. Almost all established tobacco companies are trying to gain a foothold in the emerging category, which is still largely controlled by small manufacturers. Other than Altria, Reynolds American, the second largest tobacco company in the U.S., also plans to launch its Vuse e-cigarettes nationally this year, while Lorillard already owns the top-selling e-cigarette brand in the country, Blu.

We believe that Altria has been relatively late in entering the e-cigarettes market. The company began selling its MarkTen e-cigarettes in test markets of Indiana and Arizona only in the second half of 2013. However, test results have been promising so far. MarkTen gained ~48% share of the retail cartridge market in Arizona in just over seven weeks after introduction. Accordingly, the company plans to start rolling out the product nationally by next month, which is expected to boost its market share. In addition, the company would also gain from increased marketing and expanded retail distribution of Green Smoke e-cigarettes, which it acquired earlier this year.

Green Smoke Acquisition Bolsters Marketing Strategy

During the first quarter of this year, Altria completed the acquisition of Green Smoke Inc.'s e-cigarettes business for $110 million. Founded in 2008, Green Smoke sells e-cigarettes in the U.S. and Israel. In 2013, the company's total e-cigarette sales stood at ~$40 million, which implies a market share of over 2.5%. It deals in rechargeable as well as disposable e-cigarettes sold under its namesake brand primarily through the online retail channel. However, its convenience store sales are expected to receive a boost from Altria's established distribution network going forward.

Green Smoke, being one of the premium e-cigarette brands in the U.S., fits well with Altria's overall marketing strategy focused on premium brands. The tobacco giant's portfolio includes brands such as Marlboro and Copenhagen that hold leading positions in their respective categories. The strategy is one of the key factors behind Altria's strong financial performance over the past several years. This is because tobacco companies rely primarily on pricing for their growth, which is easier to implement with premium brands.

Another key aspect of Altria's operating strategy is its focus on product diversification. The company's leading position in the smokeless tobacco category has somewhat insulated it from consumers opting for chewing tobacco and snuff instead of cigarettes, as its Copenhagen and Skoal brands hold more than 50% share of the U.S. smokeless tobacco market. The company aims to work with a similar strategy in the e-cigarettes market. Unlike MarkTen, Green Smoke e-cigarettes are not meant to closely mimic traditional cigarettes in look and feel and have a bigger, stronger battery. Therefore, it is expected to complement Altria's in-house developed offering and would help expand the company's addressable consumer base.

Cross-Licensing Agreement To Provide Further Growth

In December last year, Altria entered into a strategic agreement with Philip Morris International involving cross licensing of their lower risk products to tap the fast-growing market. While Altria controls more than half of the U.S. cigarettes market, Philip Morris International, which was spun off from the former in 2008, leads the international market, excluding China.

According to the agreement, Altria would provide Philip Morris International an exclusive license to commercialize its e-cigarette brands internationally. On the other hand, Philip Morris International would provide Altria an exclusive license to commercialize two of its "reduced risk" products in the U.S. The two companies also agreed to work together on regulatory engagement related to heated tobacco products with the FDA and e-vapor products with international regulatory authorities.

In our view, the cross-licensing agreement improves Altria's long-term growth prospects, as it will help the company's e-cigarette brands gain recognition internationally while generating royalty income at the same time.